Home >Money >Personal Finance >Have Indian hedge funds sailed through the coronavirus storm?
Investors should dive deep into the strategy the fund is following.
Investors should dive deep into the strategy the fund is following.

Have Indian hedge funds sailed through the coronavirus storm?

  • The top 8 hedge funds in India delivered an average return of 6.45% in FY 20, compared to the -26% given by the benchmark Nifty 50
  • The taxation of AIFs is different from mutual funds which are tax exempt at fund level

NEIL BORATE : Most Indian investors are familiar with equity mutual funds which deliver returns when stock prices rise. However some funds aim to make money when stocks fall or rise. These funds are also allowed to borrow money to invest. Such funds are categorized as Category III Alternative Investment Funds (AIFs) by SEBI and in colloquial terms are called 'hedge funds'.

In this piece we look at how hedge funds have performed and whether there is an investment case for them. According to data from PMS AIF world, an alternative funds platform, the top 8 hedge funds in India delivered an average return of 6.45% in FY 20, compared to the -26% given by the benchmark Nifty 50.

Much of this out performance came in the month of March when the Nifty fell by 23% and these funds on average fell by just 2.45%. Longer term performance data is difficult to get due to the relatively recent inception of hedge funds in India.

SEBI laid down a framework for AIFs in 2013, much after vehicles like mutual funds had taken root in the 1990s. Category III AIFs are allowed to benefit from rising stocks (going long) or falling stocks (going short), although some funds in this category are long only. They are also allowed to take on leverage (borrow money to invest) up to twice their capital. In other words, if the AIF has a size of 100 crore, it can borrow an additional 100 crore to invest. "It’s important we make consistent returns in investments and the long short funds offer that opportunity to investors. Markets will always reward certain stocks and punish certain stocks. Long Short (LS) funds help you participate in both," Sankalpo Pal, Head of Business Development, PMS AIF World.

In tax terms, AIF income is taxed at fund level and not investor level. “The Category III AIF will be taxed at the maximum marginal rate (highest slab rate with surcharge and cess) on whatever type of income it earns. Thus if the income is classified as business income or interest income, it would be 42.74%. However, in case of capital gains on shares it will be 15% or 10% depending on the holding period, along with surcharge and cess. Dividends will also be taxed at 35.88%, and not 42.74%," said Gautam Nayak, Partner, CNK and Associates LLP. “This is not TDS rate, it is the tax payable at the fund level. Even if the investor himself is taxable at a lower rate, he cannot claim a refund of the tax paid by the trust. However the money paid to the investor after tax paid by the trust will not again be taxable in the investor's hands," he added.

The taxation of AIFs is different from mutual funds which are tax exempt at fund level. Instead the tax is paid by the investor whenever he or she chooses to redeem units or receives dividends. This places category III AIFs at a slight disadvantage to mutual funds.

AIFs have a minimum ticket size of 1 crore. In terms of fees they typically have a 2 and 20 cost structure or a variant of the same. 2% is the annual expense ratio (akin to equity mutual funds) and 20% is the performance fee that is levied on the return generated above a certain threshold (called the hurdle rate). For example if a fund delivers a return of 12%, it may impose a 20% fee on returns above 8%. This would make the post-fee return 11.2%. Some hedge funds have a lower fee structure than this. In addition, hedge funds also levy exit loads on investors, typically up to 2 years from the investment date.

Investors should dive deep into the strategy the fund is following. "Equity Mutual Funds need rising markets to deliver returns, while long short funds do not. We go long solid compounding businesses and short weak overvalued ones and generate long term returns for investors over a 3-5 year period," said Nalin Moniz, Chief Investment Officer, Alternative Equity, Edelweiss Global Asset Management. “When the early news about the virus came out of China we continued to follow the mandate of the fund. We increased our shorts in December but that was solely because we found more shorting opportunities. The nature of our fund with its long short bets allowed us to outperform the market over the past few months of sharp correction," said Moniz.

There is very little standardization in this space compared to mutual funds. “We have two long short funds. First is the absolute return fund which aims to deliver debt plus returns, irrespective of the market conditions, over a period of time. This fund has given 150-200 bps more than liquid and other low risk funds over various timeframes," said Vaibhav Sanghvi, Co-CEO at Avendus Capital Public Markets Alternate Strategies LLP. “Second is the enhanced return fund which aims to give equity plus returns - outperforming on the upside and containing risk on the downside. Here we keep 70% of the money, unhedged, in high quality stocks. The rest 30% is used to control risk through long short strategies," he added.

Although hedge funds can take on leverage up to twice their size, not many funds take such an aggressive stance. Two fund managers that Mint spoke to said that their leverage was typically in the 105-130% range. Conversely the funds can simply increase their short positions or move aggressively into cash when they expect a market cash. “We also take on leverage to deliver higher performance in up cycles. In this fund we moved the 25 - 30 % to cash in early March, during the market crash and this has allowed us to outperform," said Sanghavi. This strategy can yield further dividends in the volatile markets following the coronavirus crisis. “For example we will look to short global cyclicals, weak leveraged financials and those companies whose revenues will be significantly hit by the covid-19 driven slowdown," said Moniz. However investors should note that the ability to take leverage makes these funds risky because leverage amplifies both gains and losses.

Financial advisors are cautious about hedge funds.

"For expected returns of 9-11%, a complicated derivative strategy, ambiguous tax position and lack of liquidity is too high a price to pay. Investors would be better of in ordinary mutual funds," said Mrin Agarwal, founder Finsafe India Pvt Ltd and co founder Womantra. Amol Joshi, founder, Plan Rupee Investment Services concurred. "Outperformance during the covid correction is too short a time frame to evaluate this category. If you consider the fees and tax position, it is only suitable for someone with an investible surplus of several crores who is looking for an exclusive product," he said

AIFs have shielded their investors from the coronavirus correction, better than plain vanilla equity mutual funds, but their success has been somewhat modest. They are also dogged by a number of issues.First, their costs are complex (with fixed and performance fees) and in some cases may exceed mutual funds. Second, their tax treatment is not favourable compared to mutual funds. Third, there is very little transparency on the kind of commissions that distributors are paid on AIFs which has led to banks pitching these products to HNIs in a big way. Fourth, their returns are not available in the public domain for side-by-side comparison with other hedge funds and indices. If you still want to invest in this type of fund considering all these hurdles, be prepared to take on a higher level of risk for a possible higher payoff. Also, pay close attention to the fund’s strategy and cost.

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